Question

Which of the following statements is true?

a. It is possible that the APT is valid and the CAPM is not.

	True
	False

b. It is possible that the CAPM is valid and the APT is not.

	True
	False

Answer 1

Capital Asset Pricing Model versus Arbitrage Pricing Model

Capital Asset Pricing Model ( CAPM)

CAPM explains the relationship between the expected return and risk of an asset. For every investment risk is involved. In CAPM, it says that unsystematic risk can be reduced through diversification but the systematic risk which is non-diversified, cannot be excluded from the market. The systematic risk can be measured by Beta. In CAPM it considers the single factor. The formula for CAPM is given below:-

Ri = Rf + βi(Rm-Rf)

Where, Ri is the rate of return of a security

             Rf is the risk free rate of return

             βi is the beta of the investment

             Rm is the return of the market

Arbitrage Pricing Model ( APT)

Arbitrage Pricing Model explains the relationship between the asset and many risk factors. Arbitrage means the simultaneous buying and selling of securities in the same or different markets. Arbitrage helps the investors to obtain the risk free return or profit from the investment. The formula for APT is given below:-

E(Ri) = Rf + β1(Rm-Rf) Δ F1 + β2(Rm-Rf) Δ F2 + … βN (Rm-Rf)Δ FN

Where, Ri is the expected rate of return of a security

Rf is the risk free rate

β is the sensitivity of the asset return

Δ F is the factor

(Rm-Rf) is the risk premium

• It is possible that the APT is valid and the CAPM is not

APT model was devolped by Economist Stephan Ross. APT model is an alternative to CAPM model. In CAPM it considers only single factor while in APT model it considers certain other factors which can be divided in to macro economic factors. Also APT has more flexible assumptions than CAPM. So, it is possile that APT is valid and the CAPM is not. Therefore, the statement a is true.

• It is possible that the CAPM is valid and the APT is not.

It is not possible that CAPM is valid and APT model cannot be valid because it is an alternative and consider valid assumptions. Therefore, the statement b is not true.

Hence, the statement a is true. i,e, It is possible that the APT is valid and the CAPM is not.